What's Weighing on Inflation?

The rules of economics suggest that inflation should be rising, but it's not. Five key factors, including technology, are keeping a lid on price growth for the near future.

For the last several years, economists have been grappling with this puzzle: Unemployment in the United States has been steadily falling, yet the costs of most goods and services have hardly budged. Average annual inflation—one yardstick of economic growth—hasn't hit the Fed's 2% target in years. Nor is it likely to this year or next.

“Recent declines in inflation are not solely 'idiosyncratic,' but also reflect broader trends that are likely to persist," says Ellen Zentner, Morgan Stanley's Chief U.S. Economist. Consequently, Zentner and her team recently lowered their core personal consumption expenditure (PCE) inflation forecast to 1.4% for 2017 and 1.7% for 2018.

In a recent report, Morgan Stanley Research looked across its coverage to understand why low inflation persists. They identified five major culprits, top of which is technology, which is pushing down prices of everything from groceries to hotel stays.

Technology's Catch-22

Ecommerce and the sharing economy have been a boon for consumers, but when it comes to inflation they are a major detractor. They improve price transparency and introduce additional supply, and that paves the way for lower prices for comparable goods and services.

Inflation expectations, which remain low, can be a self-fulfilling prophecy.

Rising adoption rates for short-term rentals, for example, could drive down revenue-per-available-room rates by 2% in 2018. Likewise, ride-sharing services have steadily led to lower cab rental prices.

Then there are the online retailers. There is little question that competition between multiple sellers, each willing to sacrifice some profit for market share, has put pressure on prices, both for online sellers and their brick-and-mortar counterparts. Meanwhile, the same dynamic in digital food delivery could depress food inflation across the board; one of the nation's largest brick-and-mortar grocers is already poised to drop prices in response.

While it's clear that technology is dampening inflation, consumer spending on many of these outlets is not yet included in the Consumer Price Index (CPI). If they are added, it could take years to show up in CPI samples. “We may have yet to witness the full extent of downward pressure these platforms present on overall prices," says Zentner.

Other Deflationary Forces

Technology is just one of many major trends that are contributing to weak inflation. Other key factors include:

Oversupply: An oversupply of used cars, multi-family housing units in some markets and other segments is further contributing to decelerating growth in prices.

Overcapacity in China: Although prices of China's consumer goods are increasing again after a period of weakness, this has yet to spill over to higher-priced consumer goods in the U.S. This is notable, as China influences roughly 40% of the U.S. core consumer goods measured by the CPI.

Dollar bull market: Because imported goods are included in inflation calculations, the relative strength of the dollar is also key. Even with the dollar's recent decline, the trade-weighted dollar index is still higher than it was in mid 2014. “A deeper and longer dollar depreciation is needed for core inflation to respond more meaningfully," Zentner says.

Lower inflation expectations: Meanwhile, inflation expectations, which remain low, can be a self-fulfilling prophecy. For every 25-basis-point decline in expectations, there is a 0.1% decline in year-over-year growth rate for core PCE, Morgan Stanley estimates.

The Fed's Likely Take?

Historically, the Federal Open Market Committee has looked to the Phillips curve—the inverse relationship between unemployment and the rate of inflation—for insight into when to dampen growth, but this seems less relevant today. Although a tightening labor market has driven up prices in some segments, such as single-family homes, it's "not enough to overcome downward pressure from other factors," says Zentner, who adds that recent hurricanes likely won't have a lasting impact on national prices either.

The Fed is then faced with a difficult task: How to balance persistently low inflation with potentially frothy financial conditions, which are the easiest they've been since before the financial crisis. Do nothing, and they risk letting the economy overheat. Raise rates too much, and they risk squelching growth prematurely.

The likely path will be to take preemptive action and raise rates, albeit slightly less aggressively than initially expected. “Following a rate hike in December, we now see the FOMC raising rates three times in 2018, versus four," says Zentner.